Spreads in Trading: What Are They?
What are Spreads?
FOREX trading is all about exchanging one currency for another. To create a universal language in which everyone understands the value of a currency in relation to another, currency A is quoted in terms of its price in currency B. This is known as the exchange rate. The spread is the difference between the exchange rate that a broker sells a currency and at which the broker buys that currency.
Let us explain further and show you spreads in action. When you invest in a currency at the prevailing exchange rate, otherwise known as the spot rate, and later sell it for a profit, the difference between what you bought it for and what you sold it for is your gain (or loss) on the spread.
Spreads can be fixed or variable, with fixed spreads remaining constant and variable spreads fluctuating based on market conditions. The size of the spread is influenced by liquidity and volatility, meaning major currency pairs like EUR/USD tend to have tighter spreads than exotic pairs. Brokers may charge spreads as their primary form of compensation, especially in commission-free trading accounts. Understanding how spreads change during different trading sessions, such as the London or New York session overlaps, can help traders optimize their entry and exit points for better cost efficiency.
Why you should pay attention to spreads
Retail traders must pay close attention to spreads, as this seemingly small charge can significantly impact their profitability, especially in high-frequency or short-term trading. A wider spread means higher transaction costs, which can eat into potential gains or amplify losses. For example, if a trader enters and exits a trade quickly, they must overcome the spread before they can turn a profit. Spreads also tend to widen during periods of high volatility or low liquidity, such as after major economic announcements or during off-peak trading hours, making trades more expensive. For traders using scalping or day trading strategies, even a few extra pips in spread costs can accumulate into a substantial expense over time.
Spreads as a way to tell good brokers from bad ones
Spreads can be a key factor in distinguishing between high-quality brokers and less reliable ones. A broker that consistently offers low spreads demonstrates a clear understanding of how crucial trading costs are for retail traders and actively works to keep them competitive. Lower spreads mean traders can enter and exit positions more efficiently without excessive costs eating into their profits. A good broker invests in liquidity providers and technology to ensure tight spreads, even during volatile market conditions, while a less reputable broker may have wider, inconsistent spreads that make trading more expensive and unpredictable. Choosing a broker with consistently low spreads suggests they prioritize their clients' success rather than maximizing their own earnings through hidden costs.
How Currencies are Quoted
When it comes time to trade FOREX and work through an online broker, currencies are always quoted in pairs, for example, the euro versus the Australian dollar (EUR/AUD). The first currency is called the base currency, and the second currency is called the quote currency. Spreads vary according to market demand, economic conditions and other factors, like the time of day (opening hours vs. peak trading) or even the time of year (close to holidays).
When FOREX brokers offer their currency trading and exchange services, they must use a term that is an extension of the spread, known as the bid-ask spread. Let us now introduce you to the bid-ask spread to show the FOREX world in action. The bid price is how much your broker is willing to pay for a currency when acting as a buyer, while the ask price is the rate the broker will pay for that same currency when acting as a seller.
If you have ever traveled to another country and needed to use a bureau de change, you will understand that it is providing you with much the same service in an airport as FOREX brokers provide to retail traders in the real world. For example, let us say you are an Australian tourist visiting Europe. When you land at the airport in Europe, the bureau de change presents you with the cost of purchasing euros as follows:
EUR 1 = AUD 1.48 / AUD 1.55
The difference between the two AUD values is the spread. The higher price (AUD 1.55) is how much you will pay to buy one euro. In our example, you purchase the amount of euros you need for your trip and leave the airport. Perhaps at the end of your trip you return to the same bureau de change and find the rates unchanged. You have some euros left over and need to sell them back to the bureau de change. This time, the lower price (AUD 1.48) is the rate at which you must sell your remaining euros to get back some Australian dollars. You will note that the bureau de change makes a profit from these transactions through the difference in the bid-ask spread. This is because it is a market maker and generating profit is completely normal. We will explain more in the next section.
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How Market Makers Determine the Spread
If we take our example and apply it to the overall FOREX market, the same principles apply. The FOREX market is a virtual world where intermediaries known as market makers coordinate transactions (just like the bureau de change). They are often highly-trained specialists, individuals or small agencies, based in cities all over the world.
Remember, it is the big players, like large financial institutions, that drive the most FOREX volumes, not retail traders, who are but a small part of the ecosystem. Market makers are skilled and experienced at ensuring an orderly flow of buy and sell orders for the currencies in which they work. They have many clients around the globe, and they are skilled at brokering massive transactions.
There is implied risk in this process as prices can change quickly, so market makers must insert a premium that involves elements of their own profit plus a premium for trading risks. In coordination, market makers across the ecosystem help determine the spread equilibrium of global currencies. For you as a retail trader, it helps to understand that your broker procures its FOREX from a market in which prices are influenced by market makers, and this is how you are presented with the spreads you see on your FOREX quote.
The Bottom Line
When you come to understand spreads, you can improve your trading success because you will learn how to apply them quickly and correctly to trades you are considering. It also helps to know what influences spread so you can visualize your place and your broker’s place in the FOREX ecosystem.
Spreads are an unavoidable cost in retail trading, but understanding how they work can give you a crucial edge. The tighter the spread, the lower your trading costs, and the quicker you can turn a profit. Choosing the best low-spread broker, trading in liquid markets, and staying aware of spread fluctuations can make all the difference in your bottom line. In the fast-paced world of trading, every pip counts—so make sure spreads work for you, not against you.
